Today’s menu:

1. Fund objective

2. How did the fund do?

3. What do they charge?

4. Top 10 holdings (and ROA Seal of Approval)

5. Conclusion

Fund objective

The Fundsmith Equity Fund (FEF) is a global equity fund that aims to be a long-term investor. The fund invests in companies with these criteria:

• high quality businesses that can sustain a high return on operating capital employed;

• businesses whose advantages are difficult to replicate;

• businesses which do not require significant leverage to generate returns;

• businesses with a high degree of certainty of growth from reinvestment of their cash flows at high rates of return;

• businesses that are resilient to change, particularly technological innovation;

• businesses whose valuation is considered by the Fund to be attractive. 

Wow! Sounds like its right up our street as Extraordinary Investors.

How did the fund do?

Since inception the fund has returned 14.8% per annum. This is ahead of the MSCI World benchmark of 12.1% per annum. That is good.

By the way, FEF’s performance is a little behind our Extraordinary Companies portfolio long-term return of 15.8%, but they have been going for longer and have the complications of running a huge fund. As the song title goes “Mo money, Mo problems”.

Now for the bad news.

FEF has underperformed its benchmark over the past 4 years and 2024 was particularly brutal. They returned 8.9% against the benchmark which returned 20.8%. That is 11.9% of underperformance. Ouch!

Here’s their recent underperformance record:

• 2021: -0.8%

• 2022: -6.0%

• 2023: -4.4%

• 2024: -11.9%

What did Terry Smith have to say about this?

He pointed out that Nvidia, Apple, Meta, Microsoft and Amazon provided 45% of the S&P500 returns in 2024. Nvidia alone provided more than 20% of the returns and FEF owns some but not all these stocks.

Are we going to let him off the hook with that explanation?

We can be understanding. Fundsmith is clear on how they invest and they are sticking to it, even if that means temporary underperformance. It is much better to be invested with a fund manager who sticks to his knitting, rather than one who chases performance. The latter fund manager does not have a proper investment philosophy and will go after whatever is doing well. That said, how long can one endure underperformance?

What do they charge?

Fundsmith charges 0.9% as an annual management fee. That’s the fee that the fund manager gets. It does not include other expenses such as trading costs, etc.

Fundsmith does not charge an entry fee (upfront fee when you invest) and they do not charge an exit fee (fee when you leave the fund). Most importantly, they don’t charge performance fees.

Fees are a controversial topic. As a client, the lower the better. Personally, I think entry and exit fees are outdated. In a competitive world, why would anyone pay those? But sometimes they sneak them in, such as with insurance policies that have an investment component. So lookout for them.

Performance fees are particularly insidious. Fund managers often levy these charges. The amount is perhaps as much as 20% of the outperformance versus the benchmark. That means if the fund manager beats the index by $100, he takes $20 and you get $80. He also charges an annual fee in addition to the performance fee. Basically his bread is buttered on both sides.

Performance fees are often sold to you on the basis that they align your interest with that of the fund manager. After all, you want him to outperform and the fee incentivises him to do so. This is a big fat lie.

Let me explain.

The first problem when someone rationalises the need for a performance fee, is the question as to what the annual management fee is for. The annual fee pays the salaries. Isn’t paying you a large salary enough for you to try hard? Or does that just get you to the office and you need more to make you really dig in.

The second problem is the performance fee is not symmetrical. When the fund manager outperforms, he takes your money. But when he underperforms, he doesn’t give you back any money. He just gets the annual fee. Clearly, there isn’t alignment if the arrangement doesn’t go both ways.

The third issue is that outperformance isn’t really under the control of the fund manager. Sure, he chooses good stocks, but whether those stocks outperform is a really a result of market sentiment. So, he gets a bonus if the market happens to agree with him. This can incentivise a fund manager to follow a momentum strategy - i.e. invest in what is going up.

The fourth issue is what are they benchmarking against? If the fee is based on outperforming the benchmark, then it follows that fund managers will choose an easier benchmark. Sometimes, they will even use custom indexes to benchmark against. The most laughable benchmark is when fund managers benchmark against the average performance of other fund managers. Most fund managers underperform the index, so why not benchmark against all the other guys who underperformed the index. I liken this to a kid wanting a reward for beating the class average at school, even if the class average was a fail.

For those reasons, I think it is excellent that Fundsmith does not levy performance fees. Overall, I think Fundsmith’s fee structure is fair. Recently, there was a bit of a hoo-ha about Fundsmith not reducing their annual management fee despite saying they might do so.

As far as I can tell, reduction of fees was a question asked early on and Terry Smith said they would not do it because they had to recover all the costs they incurred in setting up the fund. I don’t think he made any promise of reducing the fee in future.

Furthermore, as anyone in business will know. Fees only go in one direction. If they reduce the fee, they will never be able to increase it again. Understandably, they don’t want to make their business less profitable.

The counterargument is that when your fund becomes massive, like FEF which stands at £22.5 billion, there could be room to reduce fees. But let’s be realistic, that isn’t how business works. Competition is the only pressure that can force a reduction in fees.

Top 10 holdings

The ROA Seal of Approval is a made-up award that I will be giving to funds based on my analyses of their top 10 holdings (or other notable factors).

Here’s FEF’s top 10 holdings.

Fundsmith did exceptionally well. I like seven of the top ten. Two companies are borderline and one company is a hard no. I gave L'Oreal an okay because it is decent. But I had to qualify Stryker with an "ish” because it just about ticks our boxes. So let’s call it 8/10 for Fundsmith.

That is 80% which is worthy of the ROA Seal of Approval. Well done Fundsmith.

Conclusion

The Fundsmith Equity Fund appears to be a well run fund. They have many points in their favour, but they are underpeforming. This happens from time to time and is a clear reminder that no strategy will always outperform.

Perhaps the biggest lesson we can learn is that it is useful to diversify with both active and passive funds. That way you get exposure to the best of both worlds.

I would like to hear what you’re up to.

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